One Week to Go: Debt Deadlock Holds

July 2011: House Speaker Boehner and President Obama meet at the White House. (Reuters)

The United States edged closer on Tuesday to a devastating default as Republicans and Democrats were deadlocked over competing plans to raise the debt ceiling, one week before a deadline to act.

President Barack Obama, in a televised address aimed at rallying public support for a package proposed by Democrats, warned that failure to increase the U.S. borrowing limit would severely hurt the nation.

"For the first time in history, our country's triple-A credit rating would be downgraded, leaving investors around the world to wonder whether the United States is still a good bet," he said in remarks in the East Room late on Monday.

Republican and Democratic lawmakers, despite weeks of intense talks, are far apart on a deal to reduce the budget deficit, which would clear the way for Congress to lift the $14.3 trillion borrowing limit by an August 2 deadline, when the country runs out of cash to pays its bills.

Markets have been rattled by the descent of negotiations into an acrimonious stalemate, with both sides offering competing plans that are unlikely to win bipartisan support.

"Every day that goes by without a deal will see investors become a bit more defensive," said Omer Esiner, chief market analyst at Commonwealth Foreign Exchange in Washington.

Obama warned a default would inflict a tax hike on all Americans by pushing up borrowing costs on things like credit card loans and mortgages, but he sought to assure markets a deal could be reached.

"I have told leaders of both parties that they must come up with a fair compromise in the next few days that can pass both houses of Congress - a compromise I can sign. And I am confident we can reach this compromise," he said.

The dollar fell across the board, hitting a record low against the safe-haven Swiss franc, as Obama's comments indicated a swift breakthrough in the debt talks was unlikely.

Gold, seen as another safe-haven from the American and European debt woes, rose to a record high on Monday and hovered near that level on Tuesday. However, financial markets are not showing any sign of panic.

Rating agency S&P warns it could downgrade the United States unless lawmakers agree on steps to reduce the deficit by $4 trillion over 10 years.

A credit rating cut would be felt around the world. Investors will likely demand a higher return for holding U.S. government debt, a benchmark for almost all other financial markets, forcing up interest rates and sapping asset prices.

Republicans and Democrats both insist they will not allow the United States to default and many investors expect the two sides to come to an agreement as well.

"My personal belief is that the U.S. lawmakers will eventually raise the debt ceiling because the alternative is so much worse," said Guan Ong, former chief investment officer of Korea Investment Corp, South Korea's sovereign wealth fund, who now manages his own fund.

"But before we get there, I expect some level of volatility to occur and it will get worse with each day. This would be brinkmanship at its best, or worst, depending on how you look at it," he said.

Still, India's central bank said it was prepared for any market repercussions should the United States default on its debt. Central bank Governor Duvvuri Subbarao said at a press conference that India had sufficient market liquidity to deal with the impact of a default.

Democrats, who hold sway in the Senate, want to shield cherished healthcare programs such as Medicare and Medicaid and say any spending cuts in these must be balanced by changes in the U.S. tax code that generate more revenue in the future.

But Republican lawmakers, who control the House, are adamant they will not vote for a deal that includes tax increases, reflecting the determination of Tea Party conservatives elected last year to shrink government.

House Speaker John Boehner, the top Republican in Congress, must placate these demands and on Monday advanced a two-stage deficit reduction plan that would start with an initial $1.2 trillion in savings over 10 years.

It is sure to be rejected by Obama though because it would raise the debt limit for only a few months. The issue would have to be revisited in early 2012 ahead of elections due in November, making it even harder for lawmakers to come to an agreement.

"A six-month extension of the debt ceiling might not be enough to avoid a credit downgrade," he warned.

Democrats formally presented their competing plan to reduce the deficit by $2.7 trillion over the next decade, proposing an increase in the debt limit that would carry through the November 2012 election, when Obama and many lawmakers are up for re-election.

Boehner dismissed the Democratic plan as "full of gimmicks." Senate Democratic Leader Harry Reid insisted "extremists" within the Republican Party must not be allowed to dictate the outcome of the debt debate.

The Obama administration has not ruled out invoking the 14th Amendment of the U.S. Constitution to sell debt, even if Congress fails to raise the borrowing ceiling.